Thursday, October 2, 2008

Sub-prime/Credit nonsense

Since I helped contribute to the current crisis, I feel I have a unique insight into the problem. I worked at Countrywide Home Loans buying mortgages from smaller companies so Countrywide could combine all these loans into one giant loan bundle. Countrywide then sold this loan bundle to places like Fannie Mae and Freddic Mac. Supposedly the risk of a couple defaults would be offset by the huge amount of good loans in the bundle. These bundles were given AAA ratings (the same rating that basically only the US government has on its debt instruments) and investment companies would buy them up left and right.

This is not where the problem begins though. In the late 90's and early 00's the world as a whole had a lot of money and not enough places to invest it. So people were forced to think of new ways to invest money. Some people came up with the idea of investing in a bundle of mortgages since mortgages had an interest rate and therefore a measurable return. Now this would not necessarily be a bad thing except there was still too much money to invest and people were too greedy.

Because places like Countrywide needed more mortgages and most people that could afford one already had one, they were forced to relax the rules and let almost anyone qualify for a loan. I remember looking at many loans that Countrywide called "Super-Streamlined" which means that people would qualify for a loan based solely on what they said they made and how much money they said they had in the bank/other investments. There would be no verification of salary or even employment just a judgment call on whether someone in that line of work could possibly make as much as was stated (of course there was also no verification that they actually worked in that line of work). All they had to do was ask for a couple W2's to verify employment and wages. The only real verification there was, was a credit score. So any unemployed slob off the street could buy a $500,000 house as long as he was comfortable with lying and had a good credit score.

Now people are not always that dumb. Most people who could not afford a mortgage knew that they could not afford a mortgage and didn't even bother trying. But since there were commissions to be made, people went to these poorer people and lied to them. They told them that housing prices would always go up and that they would only have to worry about paying interest. If they bought the house now with an interest only loan (or a variable interest loan), they could sell the house in a year and pocket all the profit and never have to worry about paying any principle ever. So people got these loans and the housing market crashed. the values of homes were dropping and these consumers had huge payments on the horizon once the interest only period was over. They would have no ability to pay the mortgage and default.

Note: these interest only mortgages were not the worst of them. There were also negative amortization loans that worked much like student loans. Where people would not even make the interest payments for like a year and that interest would be capitalized into the principal up to 120% of the original value of the loan. So while housing prices were dropping the principal of the mortgage was increasing.

What is sub-prime anyway?
Originally sub-prime referred to anyone with a credit score below 620. Traditionally companies would make very few of these loans but would charge people a higher interest rate to compensate for the poor credit history. But with the demand for mortgages banks were lending to more and more sub-prime people. These people naturally have a higher risk of default and when these loans went into the bundles, the people valuing the expected return would take this into account and lower the return of the investment. But this is NOT were the problem was, the problem was with people who were labeled Prime, but should have been labeled sub-prime. Like I said before, the only thing that determines "Prime" is a credit score above 620. While I was working at Countrywide I had a credit score of 760 (which is pretty good), so I would have received a prime loan even though I was not making nearly enough money to pay for a mortgage in Southern California. So the problem was that these bundles were full of "sub-prime" loans that were labeled "prime." So the people valuing these bundles never accounted for these high risk loans and therefore said they were worth a lot more than they actually were.

So many investment firms and banks were paying a lot of money for these AAA rated investments. They did not know (or ignored) the huge flaw in the system. So when people started defaulting like mad on their mortgages, the people that valued these bundles (we will now start calling them Collateralized Debt Obligations or CDO's) realized their mistake and devalued all the investments. So banks and investment firms that invested heavily in these CDO's saw there investments tank almost overnight.

Most banks will hold onto little cash and sell their investments when they needed more. Since no one would buy these toxic CDO's (no one knew how low their values would go), banks could not meet there deposit obligations and they would crash.

The bailout
Now the government wants to help these firms by buying up these toxic assets. The firms will get their cash back (or at least a fraction of it) and the economy will keep on ticking. But is this the right thing? Many people made a lot of money by taking risks and taking advantage of everyday people. Now that their sins are coming back to bite them in the butt, the government wants to step in and make it all better. Yes, the economy will suffer if the government does not step in, and yes it will be hard for people to get loans, but should we just let people get away with this fraud? If banks stop lending to people, someone else will see a chance for profit and step in. That is how the market works. This problem happened because the government let their own institutions (Fannie Mae and Freddie Mac) run amok. And the solution to poor government is more government?